30 April 2010

CSCO: Look Ahead to April 2010 Quarterly Results

This post describes our model of Cisco Systems (NASDAQ: CSCO) Income Statement for fiscal 2010's third quarter, which ended on 1 May.   This quarter includes a rare 14th week.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report on 12 May.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

We begin by reviewing background information about Cisco and the business environment in which it is currently operating.

Cisco Systems, Inc. (NASDAQ: CSCO), the proud plumber of the Internet, has a dominant role in markets for enterprise networking products and services.  Cisco categorizes its products as routers, switches, and advanced technologies.

Earnings fell 24 percent in fiscal 2009, which ended last July, from $8.05 billion to $6.13 billion.  Revenue declined 8.7 percent, from $39.5 billion to $36.1 billion.  Services provided 19 percent of total Revenue in 2009.

Cisco has a market capitalization around $150 billion. 

The company has five business segments, which are defined by the region they serve: United States and Canada, European Markets, Emerging Markets, Asia Pacific, and Japan.  The U.S./Canada segment provided 53.6 percent of fiscal 2009's Total Revenue.

Juniper Systems (NASDAQ: JNPR) is usually considered Cisco's most direct competitor in the enterprise market.

Cisco has long been a serial acquirer, insatiably gobbling up companies of all sizes.  It recently completed a $3.3-billion purchase of Norway-based Tandberg, an expert in videoconferencing.

The company certainly has the financial resources for further acquisitions.  Cisco's Balance Sheet in January 2010 listed nearly $40 billion in Cash and Short-term Investments.

According to Gartner, spending on information technology is expected to rise 5.3 percent in 2010, after declined 4.5 percent in 2009.  Cisco frequently asserts its Revenue can expand over the long term at a rate between 12 and 17 percent per year.

In a major diversification effort, Cisco began promoting in 2009 the Unified Computing System for large data centers.  The platform consists of computer servers, virtualization software, storage systems [from EMC (NYSE: EMC)], and, of course, networking gear.   Tutor Perini's (NYSE: TPC) new data center was the first UCS installation.

The UCS puts Cisco into direct competition with heavyweights Hewlett-Packard (NYSE: HPQ), IBM (NYSE: IBM), and others.  HP responded by challenging Cisco on its home turf by acquiring network equipment maker 3Com (NASDAQ: COMS).

We're now ready to look specifically at the April quarter, which requires a little extra attention because of the fourteenth week.

Our starting point was Cisco's presentation [pdf] and comments during the conference call with financial analysts on 3 February 2010.  The call coincided with the announcement of the previous quarter's results.

Relevant excerpts follow:

our revenue guidance for Q3 fiscal year 2010 including our usual caveat as discussed earlier and in our financial reports is for revenue to increase in the 23% to 26% range year over year.

we believe total gross margin in Q3 will be approximately 64% to 65%

We believe Q3 operating expenses will be approximately 36.5% to 37% of revenue. We expect interest and other income to be approximately negative $10 million to negative $20 million in the third quarter, taking into consideration the interest expense associated with our debt offerings.

Our tax provision rate for Q3 is expected to be approximately 22%. We are modeling share count to be down approximately 25 million shares quarter over quarter in weighted average shares outstanding for EPS purposes.

For our Q3 FY10 GAAP earnings, we anticipate that GAAP EPS will be $0.06 to $0.08 per share lower than our non-GAAP EPS primarily due to stock compensation expense and acquisition related charges.

[emphasis added]
The guidance statements were made with appropriate caveats, which we have not reproduced here.

Since Revenue in the April 2009 quarter was $8.16 billion, the guidance for growth between 23 and 26 percent in the latest quarter establishes a range between $10.0 billion and $10.3 billion.  Because of recently reported IT industry strength, we have set our target in the upper half of the guidance range, at $10.2 billion.

For the Gross Margin, we have accepted the 64.5-percent midpoint of the guidance range.  This leads to an estimate for the Cost of Goods Sold of (1 - 0.645) * $10.2 billion = $3.62 billion.

Cisco expects its Operating Expenses, which includes both Research and Development and Sales, General, and Administrative costs, will be between 36.5 and 37 percent of Revenue.  If we apply the higher rate to the Revenue target, we come up with an estimated expense of 0.37 * $10.2 billion = $3.77 billion.  We allocated $1.275 billion of the total for R&D and the remaining $2.5 billion for SG&A.

Cisco always reports various other operating charges, such as payroll tax on stock options, amortization of deferred compensation, amortization of purchased intangible assets, and the mysterious in-process research and development.  These expenses are not normally included in Cisco's non-GAAP guidance, but we try to model the GAAP figures.  We came up with a $130 million estimate for other operating charges by taking the average charge per quarter during the last 10 quarters, discarding the highest and lowest values.

Subtracting these operating expenses from the Revenue target yields an estimated Operating Income, as we define it, of $2.67 billion.  This result is more than 66 percent above the comparable year-earlier value.

Cisco indicated that Interest and Other Income would be a net expense between $10 million and $20 million.  We selected the greater expense.

Management forecasts a 22 percent Income Tax Rate, which would lead to a Provision for Income Taxes of $584 million.

The bottom-line target for GAAP Net Income in the quarter is $2.07 billion ($0.35 per share), which would be 53 percent greater than earnings in the year-earlier quarter.

Please click here to see a full-sized, normalized depiction of the projected results next to Cisco's quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Full disclosure: Long CSCO at time of writing.  No position in any other security mentioned.

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